Twin upstarts from Fortazela – A sign of the times to come?

“International governance structures designed within a different power configuration show increasingly evident signs of losing legitimacy and effectiveness”

– Official statement signed by the BRICS leaders

On July 15, 2014, the BRIC countries announced the formation of twin financial institutions at the Fortaleza summit – the New Development Bank (NDB) and the Contingent Reserve Arrangement (CRA). The announcement has been variously received with gushing optimism about the changing world order to cautious questioning of the feasibility of the bank. Considering the wide disparity in reactions, it is instructive to understand the structure, the motivation for setting up and the implications of this newly minted multilateral institution which is being hailed by many as the sign of the times to come.

The “What”

The New Development Bank adds on to the burgeoning list of development banks internationally – a 2009 study from the Association of Development Financing Institutions in Asia and the Pacific estimated that there were 550 development banks in the world.  The NDB (having a $50Bn paid-in capital) aims to fund infrastructure and sustainable development projects while the CRA is $100bn swap line that gives each country an access to emergency supply of paid-in capital. While the initial capital for NDB is being contributed equally by each of founder member countries ($10Bn each), the CRA will have a different set of contributions from each country.

Figure 1

Fig: Initial contributions, Source: Reuters, Government of Brazil

Though the NDB in a section of commentary has been hailed as a possible alternative to the Bretton Woods institutions (World Bank and IMF), its initial capital base is lower than many of the existing multilateral banks.

Figure 2

Source: Market Realist

The bank has been structured to be open to new membership with a caveat that the founding members will hold a minimum of 55% of the voting power all the time. After much last wrangling, the BRICS decided that the bank be based out of Shanghai and while India will preside over the operations for the first five years, followed by Brazil and then Russia.

Why was it set up?

The setting up of NDB has been read as a first step towards the assertion of greater power by the developing countries and towards the breaking of dollar dominance. The NDB is the result of dissatisfaction with the current west-dominated international financial system which has not reflected the rise of the developing countries. For instance, the voting rights in the IMF for the BRICS countries are completely incongruent to the economic heft and the population of these countries.

Figure 3

Source: Financial Times

There also has been particular frustration in the style of operation of the global multilateral institutions such as the World Bank and IMF which attach sometimes unsuited and unreasonable requirements to the loans and assistance they offer. More often than not, privatization of resources is insisted which results in lucrative contracts for private companies, which are mostly based out of the west. Additionally, the perceived hypocrisy of these institutions while imposing harsh austerity measures on Asian countries after the Asian currency crisis and the acceptance of the lax stance of the European countries after the global financial crisis, served to heighten the antagonism among the developing countries towards these institutions. A more immediate trigger came in the form of rapid exodus of capital from emerging markets triggered in 2013 due to scaling back of the expansionary monetary policy in the US which highlighted the perils of over-dependence on the dollar and monetary policy of the US Fed.

Why does it matter?

The coming together of the BRICS countries to negotiate as significant multilateral institution points to the growing maturity of the bloc. This can be heralded as the v2.0 of the BRICS grouping – a shift from the being a convenient grouping of countries for investors towards tangible institution development. The impact of such a bank can be analysed with respect to 2 dimensions:

  • Global power shifts – The development of a NDB and CRA signals the viability of cooperation among the BRICS countries to come up alternatives if their demands for greater share of authority are not met. As an example, the draft IMF reforms for increasing the vote share of the BRICS countries agreed upon in 2010 is stuck in the US congressional process with no signs of any breakthrough. Furthermore, the CRA mechanism is designed to help the BRICS countries to lessen their dependence on the US Fed and the dollar.
  • Funding for developing countries – According to the World Bank, there exists a $1 Trillion funding gap for infrastructure in developing countries. In this context the NDB will provide an attractive alternative for other developing countries to acquire funds from other than western dominated multilateral institutions. The fact that a BRICS bank aims to make electricity, transport, telecommunications, and water/sewage a priority is important; the demand for infrastructure is expected to grow sharply as more countries transition out of low-income status. In terms of scale, after a couple of decades, if the membership expands along with mobilization of government financing and private funds—the BRICS Bank loans could dwarf World Bank loans. This type of success has been seen with the CAF, which now funds more infrastructure in Latin America than the World Bank and the Inter-American Development Bank combined. Over the long run, this might result in a reduced loan portfolio and consequently lower policy influence of current dominant institutions such as the World Bank. However, for the foreseeable future, given the huge demand-supply gap for financing, NDB will play a complementary role rather than supplementary one. This realization is reflected even in the official responses of the World Bank and IMF, which have welcomed the creation of NDB and CRA.

There are however several potential pitfalls for the success of NDB and CRA. The fairly heterogeneous composition of the BRICS setup – varying from quasi-dictatorial style of functioning of raucous democracy – will impose challenges in reconciling the negotiations to a common set of outcomes acceptable to all. This was already exhibited in the way the first set of decisions on headquarter location and the presidency were taken – at the last moment. Furthermore the range of scale of economies – China’s economy is almost 24 times the size of South Africa’s economy will put strain on the “democratic” nature of the institutions with China naturally wanting to impose itself.  China needs to resist overwhelming the institutions for its own advantage, in order to secure support from players such as India and Brazil.

The institutions born at Fortazela, have the potential to be harbingers of the needed change in the western dominated world of international finance. However, it will take patience and extraordinary maturity on the part of the BRICS nations for these institutions to fulfil their potential.

Should there be a “Right to Bank Account?”

Financial inclusion (FI) has become one of the top priorities of federal banks and governments across the globe. The issue demands an even greater importance here in India as the financial inclusion situation is grim. Despite being the Asia’s third largest economy, nearly 40% of the people don’t have a bank account. An RBI panel headed by Nachiket Mor, a member of the RBI’s central board, recently proposed a new class of banks, christened as “payment” banks, to be set up to enhance the coverage of financial services in India. This is a step in the right direction and this article argues as to why should the people demand for a “right to bank account”?

Financial inclusion, as defined by Zeti Akhtar Aziz, noted Malaysian economist, is “About providing an opportunity for the world’s 2.5 billion unbanked and financially underserved to participate in the formal financial system…” The global financial crisis of 2008 acted as an eye opener with regards to the importance of financial awareness.  Bringing the “financially untouched” population into the mainstream banking would not only improve their lives, but also bolster the economy.

blg1Source: Livemint

In the absence of financial inclusion, unregulated lending services sprout up. They usually ask for very high interest rates and repayment period is too short for any productive investment. They can get bullish in nature and leave customers to pay through the nose. Kate McKee, a behavioural economics expert, claims that a person caught in the claws of private moneylenders shows declining decision making and crisis management skills. This degrades performance in any profession.

Financial inclusion benefits the economy in multiple ways. It provides an easier way for the state to transfer benefits to people. It will eliminate leakages and curb corruption. Thus, the result would be a reduction in the government’s subsidy bill and putting the public money to more efficient use.

Another benefit is that having a bank account will encourage people to save money, and deposits could be used to extend capital to businesses. Growth in the formal banking sector is known to reduce reliance on “black” money for financing. Availability of affordable and adequate credit from the banking sector is known to boost the entrepreneurial spirits of people.

Achieving inclusion in the country of one billion seems a humongous task, and it indeed is, but as the old saying goes, “where there is a will, there is a way.” Several developing countries have taken innovative measure to address the issues, and the results are stellar. Kenya, for example, has leveraged the widespread presence of mobile phones to introduce a mobile-based financial services system called “M-PESA”. It is used by one-third of their population for cashless transfers, savings, financial transactions, etc. and could be replicated in India.

blg2

M-PESA Model: How it works

Even private lenders can be made a part of the financial inclusion system under strict regulatory control. Brazil has in place a network of 95000 banking agents who have helped pull around 13 million people into mainstream banking. Bangladesh has adapted its regulatory framework to suit the growth of women-led micro financing institutions.

The biggest obstacle to relaxing the norms for banking growth is the fear of banking services being exploited for money laundering or even worse, funding terrorist activities. Financial Action Task Force, an intergovernmental body, was established in 1989 to counter these issues. Mexico has tried to address the issue by having “tiered” regulatory framework. Low-value accounts relax on the background checks but are subjected to more stringent transaction restrictions.

In 2008, more than 80 developing countries came together to form the “Alliance for financial inclusion,” an international knowledge sharing network to discuss and design policies on financial inclusion. Seeing the momentum in world economies towards financial inclusion, RBI acknowledged that it is the need of the hour. Based on the proposals of panels and think tanks, it has taken several steps for the expansion of financial institutions in rural India:

  • No frills accounts: These are the most basic accounts which offer only the basic services. These accounts have zero balance requirements and have helped attract more than 12 million Indians into formal banking.
  • Relaxation of Know Your Customer (KYC) requirements: No frill accounts can be opened up by showing up any one of a variety of photo IDs. For low-risk individuals, full KYC data updating exercise has to be carried out only after every ten years as compared to the norm of five years.
  • Banks at the doorstep: The introduction of information and communication technology, e-commerce, financial inclusion fund and online updates on markets, etc. have brought banks to the doorsteps.

The statistics presented below shows that these measures have achieved partial success in increasing the penetration of financial institutions in rural areas. “Crisil Inclusix Index” is used as a measure of FI. It collates three crucial parameters of bank penetration: branch penetration, deposit penetration and credit penetration. The Index has increased from 40 to 35 in the last five years, but it is mostly high for the states with high literacy. This implies that the poor, uneducated people who truly need an account are still excluded.

blg3Source: Livemint

 Under the recent proposal of RBI, existing banks are going to be allowed to open subsidiaries serving as payment banks. The Panel further proposes to have a universal electronic bank account (UEBA) for every person on the lines of the Unique Identification card scheme of central government.  Experts welcome the Mor’s proposals and believe that the concept of “payment banks” could prove to be a game changer. As Shinjini Kumar, head of banking at PWC India commented in financial express “I definitely think the proposed payment banks are better suited to achieve the objective of increasing penetration compared to the universal banks,”

Financial inclusion of the bottom half of the financial pyramid is an arduous, but crucial task that requires government will, support from leadership across political parties and careful policy crafting by RBI. We have this opportunity of leveraging the dormant potential of the financially secluded section of our economy. Who knows, it may herald a new era of growth and prosperity for all. So yes, it is time for government to give some serious thought to “Right to bank Account.”

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Vaibhav Kumar Singh is a PGP-2 student at IIM Ahmedabad and a member of Consult Club. He did his internship with The Boston Consulting Group. Prior to joining IIMA, he worked as a Software Development Engineer at Microsoft and as a research scholar at INRIA, France. He is a graduate in Computer Science & Engg. from IIT Jodhpur.

Banking Licenses for Corporates: Is there a catch?

On 20 December 2012, the Parliament gave its nod to the long-awaited Banking Laws (Amendment) Bill, paving the way for issuance of new bank licenses by the RBI. And now, one of the most awaited developments in the banking sector is the RBI`s announcement of the guidelines for new banking licenses. While the RBI has been trying to expedite this announcement, indecision regarding grant of banking licenses to corporate houses has been stalling the process.

While the RBI is opposed to letting corporate houses enter the banking sector, the Finance Ministry believes the RBI`s apprehensions are exaggerated and wants the RBI to change its stance. Both the sides have certain valid points and at stake is the growth of the banking sector.

India is one of the most under-banked nations among the bigger economies in the world. (The loan-to-GDP ratio is a barometer for a country`s banking penetration. India`s loan-to-GDP ratio (2011) stands at 75% vis-à-vis China`s 146% and the US` 233%.) New banking licenses are a major step towards tapping the demand for banking services. Though the number of serious aspirants for a bank license this time could number more than 20, the RBI is not likely to issue more than four. (In 1993, when the RBI licensed some private banks, it received 113 applications. Only nine were approved.)

The RBI has been known for its conservative stance in dealing with issues such as inflation and the new banking licenses are no different. RBI`s primary argument against allowing corporate houses to own banking corporations is the fear of conflict of interest. Hundreds of crores of public money might find its way from the banks to the other group companies. Similarly, it is feared that if realty firms are allowed to own banks, they will use them to fund property development and sell risky projects, which in turn could promote a property bubble.

After a string of collapses, the Indira Gandhi-led Congress government had nationalized most large banks in the 1960s. There were accusations of widespread abuse of public funds by bank owners, who siphoned off money to run risky businesses. The RBI’s unwillingness to grant licenses to corporate houses stems from this and the fact that there is no way to ensure that the business houses will change their ways. Similar considerations have also influenced the RBI’s opposition to real estate firms such as DLF.

Of late, the RBI has also found support from leading figures like Nobel laureate Joseph Stiglitz, chairman of the Prime Minister’s Economic Advisory Council C Rangarajan and economist Percy Mistry. The IMF has also supported RBI`s stance in its report “India: Financial System Stability Assessment Update”.

On the other hand, several leading corporate houses like the Bajaj group, Aditya Birla Group and Reliance are keen on starting banking operations in India. One of the major arguments being put forward by the corporates and the finance ministry is that the Banking Laws (Amendment) Bill gives the RBI sufficient powers to prevent the above-mentioned diversion of public funds. Under the new bill, the RBI can supersede the board of directors of a bank for up 12 months if it feels that the board is not working in the interest of shareholders and depositors’.  In such a case, RBI could run the bank by appointing an administrator during the period. Being armed with such powers, the RBI can effectively regulate and manage the functioning of banks.

Secondly, several of the interested corporates such as the Aditya Birla Group, Mahindra & Mahindra and the Bajaj Group already have full-fledged non-banking financial companies taking deposits and lending funds. These companies have sufficient experience in handling money from a large number of retail investors; they have also created credibility and trust in this regard.

Lastly, the winners in the earlier round of bank license issuances have had a mixed record. There are successes like ICICI Bank (which converted from a development financial institution), HDFC Bank and Axis Bank. But two new banks — Centurion Bank and Bank of Punjab — merged and were later acquired by HDFC Bank. Global Trust Bank was taken over by Oriental Bank of Commerce after a major scam almost wiped out its net worth. So, one can`t say for sure that keeping corporates out of banking will reduce bank failures.

Finally, the middle way being suggested is that priority be given to non-corporate entities or merchant banking institutions who will be “graduating” to retail banking after the licenses. Also, corporate houses shouldn`t be completely barred from the process. The RBI must use its new-found powers to allow greater banking access to the populace while running a tight ship, as it has in the past. There is no other way to increase banking penetration in a 1.25-billion strong country, where over 40% of the adult population doesn`t have access to banking services.

Abhinav Tripathi is a PGP1 student at IIMA, and is member of the Consult Club here. He graduated from BITS Pilani (Pilani Campus) in 2009 with a B.E.(Hons.)  in Computer Science. Prior to joining the post-graduate program at IIMA, Abhinav worked at Equirus Capital, a boutique investment bank.

Strategy Digest Vol 1 (Jan)

BMW and Affordability

An affordable BMW sounds like a classic oxymoron. Surprisingly, BMW has gone ahead with a well thought out strategic move to launch the entry level SUV – BMW X1 – in India. The X1’s price tag at INR 22 to INR 29 lakhs puts it in direct competition with the Honda CRVs and Toyota Fortuners of the extremely fast growing SUV segment in India.
The high end luxury car market in India is growing at an astonishing 74%. The playground offers attractive rewards with ever growing sales figures and BMW seems to have played the card just right. The BMW brand tag offers much more value to the Indian customer than a Toyota or a Honda and that is exactly where the BMW X1 scores over the competition.
However, if BMW really wants to conquer the Indian market even more convincingly it needs to capture the depth of the market that extends beyond the metros of India today. It needs to establish a robust after sales service network to make sure that models like X1 realize the sales potential they seem to possess. The X1 is a great launch and it’ll be interesting to see how Toyota, Honda and Hyundai face the new found competition from the grand daddy of automobiles.

The Mobile Store: Ready to evolve

With over 1200 stores and a 45% share of the organized cell phone retail market in India, The Mobile Store has been going great even with a strong pressure on margins. With a drastic shift in consumer preferences towards smart phones and falling price tags, The Mobile Store plans to change the phone shopping experience for its customers.
The Mobile Store plans to develop 300 of its stores across 50 cities into experience stores. These stores will allow users to get a feel of the phone, utilities, apps and new technology. It plans to do away with the cheap plastic dummy phones that we get to see presently. With trained Mobile Store personnel who will help the consumers choose apps and phones according to their needs, it plans to make it interactive for its consumers to make a wise choice while they buy a phone.
This plan undertaken by The Mobile Store is capital intensive and will surely put heavy pressure on the already squeezed margins in cell phone retail. Currently a retailer earns anywhere between 5-8% on the price. Moreover, the market is heavily price conscious and people make it point to get the cheapest deal even after they try out phones at outlets such as The Mobile Store. The implementation of the plan on a massive scale is also an issue with aggressive retailing tactics being employed by a growing number of competitors. 

Bypassing investment bankers in valuations

The selling of Honda’s stake in Hero Honda, Ranbaxy’s sale to Daiichi, Fortis-Wockhardt deal and the $3.7 bn Abbott-Piramal deal among many have a strikingly common story: There were no bankers involved in the valuations. It is a recent trend that has emerged lately when a lot of corporates strongly feel that “No Banker can ever know their business better that them”.
To add to it, more than 80 percent of the banker-madated deals in India are conducted completely by the promoters themselves and the bankers are left to pure mathematical execution. This trend seems to be fully justified and also enhances the confidentiality aspect of the deals. Information leaks have been a major cause of mammoth deals being brought down in a matter of days and bypassing the bankers seems to be a way of avoiding that. Other major examples include the TATA-JLR deal where the valuation was done by Tata’s close team and not bankers advising or executing the deal.
The bankers on the other hands are not losing out on the dealbook business but their profile of work is shifting more towards the financing, fund raising and implementation phases of the deals. It will be interesting none the less to follow the role of bankers in the deals to come in 2011.